Stock Market Analysis and Perspective On Risk vs. Reward – Part II

by the Curmudgeon with Victor Sperandeo


So very much to say, but so little time and space!!!  This is the 2nd article on Risk vs. Reward in the markets.  The first article can be read here.  If readers email comments or requests to the Curmudgeon, there may be a part III.  Otherwise not!

Corporate Profits Recession Continues:

Dow Theory Letters, OP 8 Dashboard, and USA TODAY have joined the CURMUDGEON in expressing utter amazement of the mind boggling disconnect between corporate profits and stock prices.  Here’s an excerpt of a recent USA TODAY article: 

Big downward revisions to profits are just the tip of a disturbing trend for investors, who have been counting on a powerful profit rebound to start in the third quarter and snap what's been four-straight quarters of profit declines. Analysts expect 82 companies in the S&P 500 to report at least 5% lower profit in the third quarter than they were forecasting a month ago, according to S&P Global.

It's more than just a few unlucky companies. S&P 500 companies as a whole are barely expected to show profit growth - just 0.4% - in the third quarter. That's down from 2.2% growth expected back on July 1 and sinking fast, says S&P Global.

Using a different methodology, Zacks Investment Research is calling for S&P 500 profits to decline 2.2% in the third quarter.

"The second-half recovery has moved on to be a first-half of 2017 recovery," says Sheraz Mian, director of research at Zacks Investment Research. "It's getting pushed back."

Here’s an excerpt from the August 15th commentary from Matthew Kerkhoff of Dow Theory Letters titledWandering into the Stratosphere:

A year and a half ago, if you knew that corporate earnings were going to decline for the next 5 quarters, would you have expected stock prices to go up, or down?

I think almost unanimously, anyone asked that question would’ve said down. That includes myself. Yet now, with the S&P 500 about to lock in its 5th straight quarter of year-over-year earnings declines, the stock market is firing on all cylinders.

The last time the large-cap index recorded five consecutive quarters of declines was from Q3 2008 to Q3 2009.  From peak-to-trough, this period saw the S&P 500 lose roughly half its value before beginning to recover.

Q&A with David Aurelio of Thomson Reuters I/B/E/S:

Curmudgeon:  What was the S&P 500 earnings YoY % decline or advance for Q2, Q3, and Q4-2016?

"The Q2 2016 blended Earnings growth estimate is -2.5%.  Q3 2016 earnings for the S&P 500 are expected to decline by 0.4% and Q4 2016 earnings are expected to increase by 8.3%."

Curmudgeon:  Why the huge increase in the 4Q-2016?

David: “It is a combination of the energy sector no longer having a drag on the earnings growth rate due to the sector’s low earnings base in Q4 2015 along with high positive growth expectations for several of the other sectors.”

Victor’s Comments:  Financial Bubbles and Today’s Central Bank Monetary Policies

What can say today about the nature of today’s equity and bond markets?  Are they financial bubbles or somehow justified by fundamental factors? 

In this article, we provide facts, opinions, and circumstantial evidence to let the reader decide.

In a terrific book titled, Manias, Panics and Crashes, by Charles P. Kinderleberger and Robert Aliber, the authors list the big ten financial bubbles:

1. The Dutch Tulip Bulb Bubble 1636

2. The South Sea Bubble 1720

3. The Mississippi Bubble 1720

4. The late 1920s stock price bubble 1927–1929

5. The surge in bank loans to Mexico and other developing countries in the 1970s

6. The bubble in real estate and stocks in Japan 1985–1989

7. The 1985–1989 bubble in real estate and stocks in Finland, Norway and Sweden

8. The bubble in real estate and stocks in Thailand, Malaysia, Indonesia and several other Asian countries 1992–1997

9. The surge in foreign investment in Mexico 1990–1993

10. The bubble in over-the-counter stocks in the US 1995–2000


Do you think the current stock and bond markets should be listed as number 11?

From the chapter "Speculative Manias" the authors wrote:

Rationality of markets

The word ‘mania’ in the chapter title suggests a loss of touch with rationality, something close to mass hysteria. Economic history is replete with canal manias, railroad manias, joint stock company manias, real estate manias, and stock price manias. Economic theory is based on the assumption that men are rational. Since the rationality assumption that underlies economic theory does not appear to be consistent with these different manias, the two views must be reconciled.

What then is the key assumption that is causing contemporary financial markets to disregard the obvious, and look like a mania?                                                                                

Answer:  Central bank monetary policy!  

Let’s examine three aspects of that:

1.    Ultra-low, zero, or negative short term interest rates.                                                                                                                       

With one exception, negative interest rates have never taken place in history before 2009. The first negative interest rates were in 2009 in Sweden and then 2012 in Denmark.  The exception was the Swiss government’s brief move to counter currency appreciation in 1970. 

On Saturday August 13th, the Financial Times (on line subscription required) reported that there are currently $13.4 Trillion of negative interest rate bonds and notes worldwide.

Today’s global central bank interest rate policy is so (off the wall) extreme, it is difficult to comprehend the mentality of doing more of what clearly does not and has not worked at all for the economy or most people. 

Analogy: This policy is like going to a restaurant where they charge you for dinner, but do not give you any food or drinks you ordered. What would happen? The restaurant would stop getting customers, and then lose money.  Similarly, zero or negative interest rates are the reason why European banks are in deep declines.

Mark Carney head of BoE was reported to say in a Financial Times (August 13- 14, 2016) editorial by Eric Lonergan: "Interest rates are a spent force" and that "I'm not a fan of negative rates." That’s after the BoE cut UK interest rates to 25bps- an all-time low!

2.   Is QE or printing money (via “book entry”) to buy government, mortgage or corporate debt, and then putting that money in the financial system helping a nation’s economy?

Clearly not!  But it does boost equity and bond prices. That is part of what is driving the financial markets mania.   Participants (buyers) believe that the Fed (or ECB or BoJ or BoE, etc.) will do what is necessary to keep markets up.  This investor belief is now deeply ingrained and is a significant cause of the mania.                                                                                                                                                          

3.  Central banks are buying stocks, as Japan has happily admitted to buying enormous quantities of exchange-traded funds (ETFs). The BoJ is already a top-five owner of 81 companies in Japan’s Nikkei 225 Stock Average.  The Japan Central Bank is on course to become the No. 1 shareholder in 55 of those firms by the end of next year, according to estimates compiled by Bloomberg from the BoJ’s ETF holdings.

BoJ Governor Haruhiko Kuroda almost doubled his annual ETF buying target last month, adding to an unprecedented campaign to revitalize Japan’s stagnant economy.  [The Curmudgeon has repeatedly described BoJ’s stock buying as “ultra QE on steroids.”]

The key question to ask is this:

Are the Fed, the ECB, and BoE also buying stocks, but clandestinely?

-->The circumstantial evidence says 99% YES!

Curmudgeon Note:  We have previously provided anecdotal evidence that the Fed or Plunge Protection Team (PPT) has bought index ETFs and stock index futures to stem any serious decline in stock prices.  Victor now asserts that the Fed buys US stocks (via index futures and/or ETFs) after release of economic bad news to make things look good, even if they are really not.


Sidebar: The Trouble With Central Banks by James Dorn (IBD August 15, 2016):

[This editorial excerpt strongly supports Victor’s points 1. and 2. above]

The reality is policies aimed at lowering long run interest rates by large-scale purchases of government and corporate bonds pose significant risks and have done little to increase real GDP growth or private investment.  The desired wealth effect is, in fact, a pseudo wealth effect that will disappear when rates rise.

With yields on longer-term bonds reaching record lows, there is increasing pressure on pension funds and insurance companies to take on more risk in the reach for yield so that promised future benefits can be met. 

Meanwhile, savers are earning next to nothing and the forgone interest income means that consumption possibilities diminish unless households take on more debt.  Low or negative rates have also led to huge amounts of new debt taken on by corporations (mostly for stock buybacks) and by governments. If interest rates rise even a little, longer-term bond holders will take large losses.

The expectation of further accommodative monetary policy in England and the uncertainty of Fed policy mean further financial turmoil. Stock prices and other asset prices ultimately depend on real economic growth, not on monetary stimulus. Without structural changes, including entitlement reforms, political pressure will be on central banks.

That is a dangerous policy path. The manipulation of interest rates by central bankers to support asset prices and fund government debt is a recipe for disaster. Holding rates too low for too long helped usher in the Great Recession. Now rates are even lower.  [Curmudgeon:  that means even more risk of a huge financial meltdown!]

The problem is that if inflation heats up, nominal interest rates will rise and asset prices decline, including the prices of assets on the balance sheets of central banks. The longer that central banks experiment with unconventional policies, the higher the risk of future financial turmoil.

Even without inflation, central banks are distorting interest rates and politicizing credit allocation — favoring big government, big business and big investors. Central banks have lost independence by bowing to financial markets and the insatiable appetite of governments for cheap credit.

It is time to rethink current monetary arrangements and to examine alternative monetary regimes. Central bankers have too much power and too little humility regarding the limits of monetary policy.


Recent Problem Executing QE by BoE:

The first sign of a problem was reported in the Financial Times on August 10th, "Bank of England runs into trouble on second day of post-Brexit QE drive." The BoE couldn’t buy all the bonds they wanted to "because pension funds and insurance companies struggling with a deepening funding crisis refused to sell gilts to the central bank."                          

The key to the "why the refusal to sell bonds" is what do you replace the bonds with?  It is much safer having bonds and high rated corporate debt than keeping money in a checking account.

Also yields are dropping, and to exchange lower coupons for higher coupons is killing pension funds and insurance companies. They need the cash flow of higher coupons for their beneficiaries. The lower yields (due to central bank bond purchases) is not as relevant to those companies’ cash needs.

The end of the story is still in play, but we all should note the change that is taking place in executing QE.

Curmudgeon Reference:   Read more about this BoE problem here.  

Victor’s Questions to ponder:

·       Will global central banks continue what they are doing, even though it hasn’t worked and some (like the Curmudgeon) say it’s destroying the financial system and distorting financial markets?

·       Will a geopolitical event, or some other negative surprise, cause the markets to decline? 

·       Will “dominoes fall” if central banks can’t stop such a decline (by flooding the system with more liquidity or creating more money out of thin air)?

Victor’s End Quote:

After reading about manias perhaps one should keep this simple sentiment in mind, stated by one of the world’s greatest financial minds:

"I made my money by selling too soon."  by Bernard Baruch

Good luck and till next time...

The Curmudgeon


Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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